Financial markets are booming and
yield spreads over Bunds for the bonds of the
distressed eurozone states have narrowed. Ireland has
announced that it is exiting the EU-IMF bailout programme and
going it alone for the funding of its future budget deficits
and debt rollovers, having built up a cash reserve of 20
billion with which it can service its debt without further
issuance until 2015. Spain reckons that it too can exit its
banking bailout programme without further recourse.

So all is looking well in the eurozone and any new bout of
crisis has receded beyond the horizon. Or has it? In my view,
there will be a renewed crisis. This time, though, it will run
from the banks to the sovereigns in peripheral states.

Eurozone banks are still inadequately deleveraged and
capitalized, especially in the peripheral economies. They face
substantial rising bad debts in the corporate and household
sectors in 2014. At the same time, sovereign debt
sustainability is set to worsen, GDP growth is (and will
remain) zilch; fiscal and economic reform is nonexistent; and
banks are vulnerable on their loan books to the corporate
sector as much as on their massive holdings of domestic
sovereign debt.

And the eurozones banks, particularly in the
periphery, face the tests of the European Central Banks
asset quality review (AQR) and stress tests over the next year.
This will provide transparency, but not the means of addressing
the flaws it will uncover.

In the meantime,
as I argued in my last column, the architecture of budding
European banking union is riddled with Gruyère holes and
is under-resourced. The political ambition to keep all funding
resolutions dependent on private sector bail-ins and national
government resources is likely to make banks more vulnerable to
runs on them.

The nexus connecting
excessive private and public debt in the eurozone is the
banking system. Bank credit is still contracting; loan rates
are still high in peripheral economies; and the breakdown in
intra-eurozone credit and capital flows remains. There is an
adverse feedback loop in which the eurozones banks are
the weak link between still high private-sector (corporate and
household) debt and rising sovereign debt.

As a result, banks in Italy, Spain, Portugal and Ireland
will need to recapitalize in total to the tune of around
100 billion  twice the forecasts being made for the
results of the
ECBs AQR stress tests. Two-thirds of this recap would
have to be for Italian banks.

Italian banks hold over 30% of all Italian sovereign debt
and their holdings constitute over 10% of all bank assets.
Italian bank holdings of government debt are more than 2.5
times larger than tier 1 capital. If Italian government bond
prices were to fall by, say 20%, Italys banks would face
around 80 billion in potential losses, if their holdings
were marked to market. The 10-year benchmark yield would rise
from 4.2% now towards 6%, a level last seen at the beginning of
2012.

Square the circle

And the eurozones sovereign debt profile is not
improving. Budget deficit targets for 2013 were relaxed for the
peripherals by the EU bodies. But even so, many peripheral
governments have failed to meet them. Greece has fallen short
and will have a fiscal gap to make up in 2014 and 2015.
Portugal sought to square the circle by siphoning off pension
fund reserves. And Greece, Spain, Portugal and Italy met their
spending targets by various one-off measures.

Despite the bottoming of eurozone economies in mid-2013,
prospects for nominal GDP growth in 2014 and 2015 remain well
below trend and, most important, below a level necessary to pay
for rising interest costs on public debt. In 2014, gross public
debt ratios in all the peripherals will continue to rise to
levels more than double the EU long-term fiscal target of 60%
of GDP.

Italys gross public debt ratio is now over 130% of
GDP, more than twice the EUs Fiscal Compact target of 60%
by 2030 and is still rising. And Italys banks are tied
more closely to the sovereign than any others in Europe. A
crisis focused on Italy and the nexus between the sovereign and
weak banks would be tough to deal with. Italy thus remains the
real flashpoint for a new round of the euro debt crisis in
2014.

Further reading on Euromoney

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